Tax Shelters: Will They Stand Up?

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Remember the war on tax shelters? During the Clinton Administration, then- Treasury Secretary Lawrence Summers called abusive tax shelters “one of the most serious compliance problems in the U.S. tax system.”

He backed up his words with new regulations on tax-shelter promoters, greater disclosure requirements for corporate taxpayers, and a more-aggressive Internal Revenue Service audit staff.

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With the election of a business-friendly President in George W. Bush, some tax directors might have expected the IRS crusade to be toned down. But that hasn’t happened. Despite recent taxpayer victories in court against the IRS, Assistant Secretary of Treasury for Tax Policy Mark Weinberger has repeatedly warned that the IRS will continue to enforce existing tax-shelter rules vigorously.

Fueling that resolve is the fact that tax shelters have become a far more politically charged issue in the past few months, thanks to–you guessed it–Enron. Along with all the other financial engineering tricks that Enron pulled off, it managed to pay next to no income tax in the past five years, despite reporting robust–if ultimately illusory–earnings in its financial statements. Add in the fact that the federal government is once again running budget deficits, and the topic of tax shelters makes for good sound bites.

“I’m a tax-cutter, but if there’s one thing I can’t stand, it’s a tax cheat,” said Sen. Chuck Grassley (R-Iowa) in a January 17 press release. The ranking minority member of the Senate Finance Committee has vowed to help introduce new legislation that will make it easier for the IRS to combat abusive tax shelters, which it estimates rob the Treasury of at least $10 billion annually.

All this attention, of course, creates a potentially greater source of risk for corporate finance chiefs seeking to reduce their tax burdens. While the IRS defines a tax shelter as any transaction undertaken with a significant purpose of tax avoidance or evasion, CFOs are expected to make investment decisions on an aftertax basis. They are also expected to consider all legal means to minimize the corporate tax burden. “It’s what I get paid for,” says one tax director of a large retailing company. “Like most taxpayers, I want to take an aggressive position if I think there’s a reasonable chance of succeeding,” adds another in the hospitality industry.

Those chances of success may have increased in the past year, thanks to favorable outcomes in court for a number of companies. Recent cases have shown that judges don’t always have the same notions as the IRS about what constitutes a “valid business purpose” or when a transaction has “economic substance.” Still, legal experts say the verdicts don’t necessarily suggest that the IRS’s campaign against tax shelters will be quashed by the courts. “It’s halftime, and too soon to tell if the advantage has shifted to the taxpayer,” says attorney Jean Pawlow of Miller & Chevalier, in Washington, D.C.

Show and Tell

For the IRS, the advantage is clearly in having information. Since February 2000, the agency has required promoters of tax shelters–which include accounting firms, banks, law firms, and securities brokers–to register all tax shelters they market to individual and corporate taxpayers. They are also required to supply the IRS with lists of all the investors that undertake the transactions. “It’s supposed to throw sand in the gears,” says Robert Gordon, president of securities broker Twenty-First Securities. “The purpose of it is to make things easier for government auditors, but it also makes taxpayers think twice about using something on a list.”

As of last September, more than 3,000 shelters had been registered and the Tax Shelter Committee of the Large and Mid-Size Business Division of the IRS had approved investigations of five promoters that had failed to register shelters. While the IRS hasn’t released any information on the investigations, it did announce an agreement with Merrill Lynch last August “relating to tax-shelter registration penalties” that resulted in “a substantial payment” to the IRS. Others could be facing penalties as well. “I think there are still quite a few shelters that haven’t been registered,” says David Harris, head of the Office of Tax Shelter Analysis, which was created by the IRS two years ago.

The February 2000 regulations also require companies to disclose all potential tax shelters in their tax returns. The IRS has composed a list of 16 “reportable transactions” that it considers potential shelters, but requires all transactions in which tax avoidance is a “significant purpose” to be reported. So far, companies have been less than forthcoming. “A lot of practitioners have said that they would like to disclose their transactions, but are concerned about tax-understatement penalties,” says Harris. And not without reason: penalties can reach 40 percent of the tax savings at issue.

In an effort to bring more transactions out of the woodwork, the IRS recently agreed to waive penalties if companies voluntarily disclose questionable transactions by April 23. Says Harris: “CFOs and tax planners have to understand that we have focused our resources on these transactions, and if promoters have marketed their products to a number of people, we’ll find the companies on a list.” Apparently, finance chiefs are willing to take that chance. While Harris expects the number of disclosure filings to increase as the deadline approaches, few companies have yet taken the IRS up on its offer.

And the Verdict Is?

One reason why finance chiefs aren’t rushing to disclose their potential shelters may be the string of recent courtroom defeats suffered by the IRS. Before last year, the IRS was untouchable, amassing an 11-0 record in tax-shelter cases, most of which were tried in the U.S. Tax Court. Since then, however, several of those victories have been reversed in district courts. “What a difference a year makes,” says an attorney who closely followed Compaq Computer’s successful appeal of a U.S. Tax Court ruling on a so-called dividend-stripping transaction in the Fifth Circuit Court of Appeals. “A year ago the government was winning everything, but now the courts of appeal are taking a cold, hard look at the facts.”

While the variations on tax shelters are infinite, their ultimate aims are the same. Some, such as Compaq’s ADR (American Depository Receipt) arbitrage strategy, generate capital losses to offset gains. Other transactions, like the purchase of corporate-owned life insurance policies, involve the borrowing of large sums of money in order to deduct interest payments. In all tax-shelter cases, the IRS essentially argues that the company would not have undertaken the transaction were it not for the tax benefits it generated. Companies can counter the argument by proving the transaction has the potential to produce a profit.

In Compaq’s case, that argument was fairly straightforward. On September 16, 1992, the company purchased 10 million shares of ADRs in Royal Dutch Petroleum immediately prior to the company declaring a dividend. It then sold the ADRs ex-dividend the same day for a loss. The company received dividends of more than $22 million on the briefly owned investment and recorded a capital loss of just under $21 million on the sale of the stock, which offset previously incurred capital gains. It also claimed foreign tax credits of $3.4 million for taxes paid to the Netherlands government. The IRS argued that the transaction did not have the potential for profit and that the company would not have entered into it were it not for the foreign tax credits it claimed.

The company, on the contrary, argued that it had indeed made a pretax profit of $1.9 million and an aftertax profit of $1.25 million on the arbitrage transaction. The IRS treated the Netherlands tax payments as an expense of the transaction, without treating the foreign tax credits as a benefit. Judge Edith H. Jones chided the IRS for attempting to “stack the deck,” and ruled that the transaction did in fact have economic substance. “It had nothing to do with taxes,” says Twenty-First’s Gordon, who pitched the transaction to Compaq. “Most brokerage firms do it for their own account, so we offered it to clients.”

Another company to notch a court victory is United Parcel Service. Last fall, it successfully appealed a huge adverse Tax Court verdict in the 11th Circuit Court. The IRS argued that in 1983, when UPS formed a Bermuda-based subsidiary to offer insurance on packages to its customers, the transaction served no business purpose other than to confer tax-free benefits on UPS shareholders. The estimated liability of the company was $1.8 billion. UPS, however, convinced the court that the transaction did have a valid business purpose. “The state insurance commissioners were starting to exert their influence, and we didn’t want to be regulated by 50 different insurance commissioners,” says UPS spokesman Norman Black.

Other companies that had favorable verdicts last year include American Home Products and IES, a company now owned by Alliant Energy Corp. That makes the current score in court cases 7-6 for the government, with several cases still headed for appeals, says attorney Pawlow. But while the recent court victories by taxpayers may be encouraging to CFOs, they still don’t provide a clear indication of what is acceptable tax planning and what is not.

“It shouldn’t be left to the courts to sort out,” insists Pawlow. And neither new IRS rules nor tax legislation is necessarily the best answer. Many worry that new rules could have unforeseen, negative consequences for legitimate transactions.

“This is the perfect environment for the IRS and tax practitioners to think outside the box on how to resolve these issues,” says Pawlow. She suggests a fast-track mediation program and prefiling communications between taxpayers and the IRS on how a transaction will be treated for tax purposes. Nice ideas, but don’t hold your breath. For the time being, CFOs will have to continue weighing the risks and rewards of tax-saving transactions on their own.

When tax practitioners pitch a potential tax-saving investment to CFOs, they often supply an “opinion” on whether the transaction would hold up to an IRS challenge. These opinions usually protect taxpayers from possible underpayment penalties.

Many of the opinions, however, amount to rubber stamps, say critics, and involve little due diligence on the part of tax practitioners. “We’re concerned about potentially abusive transactions that have proceeded based on inadequate tax opinions,” says Herb Beller, chair-elect of the American Bar Association’s Section of Taxation.

In response, the Treasury Department has proposed amendments to Circular 230, the regulations that govern the conduct of tax practitioners. The new rules will impose a higher standard of due diligence on practitioners who provide opinions that a transaction is “more likely than not” to survive an IRS challenge. Not surprisingly, practitioners are nervous. The new rules could make them more vulnerable to censure, fines, and even disbarment for rendering opinions without adequately addressing all material facts of the transaction.

At the heart of their concerns is the Internal Revenue Code definition of a tax shelter as any transaction with a “significant purpose” of federal income tax avoidance. Prior to 1997, the definition was a transaction with the “principal purpose” of tax avoidance. Both the American Institute of Certified Public Accountants and the ABA argue that the new definition is too broad in the context of professional liability, and that it would apply to virtually everything tax practitioners do. “People are concerned that ‘significant’ sweeps in too many legitimate transactions,” says Beller.